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Bank Competition, No Simple Solution

One can tell that the UK general election is just over one year away. New policy prescriptions are flowing thick and fast from the three leading parties. Unfortunately there are three areas where the opposition Labour Party always appear to come unstuck. They are Banking, Business and the Economy.

Last week, the Labour Party Leader, Ed Milliband once again went for the sounds good sound-bite; just as he did last year when he said he could freeze energy prices. In the midst of bonus season in the “City” he announced that if Labour were to win the General Election of May 2015, then on the first day in office he would call on the Competitions and Markets Authority. They would be charged to undertake a review of the UK banking system with a view to setting a cap on market share by number of bank accounts. He would similarly force the existing “Big Five” …Barclays, HSBC, Lloyds, Royal Bank of Scotland (RBS) and Santander to sell off branches across the nation and sell them to two new “Challenger Banks” that should be in operation by 2020.

It can be accepted that there is a need for reform as the UK does have a heavily concentrated banking industry to say the least. The concentration ratio for the leading five or the similar Herfindahl Index is 80% for private bank accounts and 92% for business lending. This is clearly a structure that is classical oligopoly and as such permits informational distortions that has been in the past an incubator for the miss-selling of financial services.

However, this policy in itself is no guarantor of increased or improved competition. Firstly, capping a good bank that is seen as delivering an excellent service with fair fees is actually denying a new generation of would be bank customers the opportunity to open banking facilities according to their choice. Existing clients whose account is listed with a specific local branch may suddenly find themselves paired off with a new market player. Well…maybe they do not wish that. Of course, one would expect that new banks and the management teams would have passed scrutiny and be judged as a fit and proper person to conduct bank business. One has to ask how can we trust the Labour Party when they oversaw the appointment of a former Labour Councillor, Paul Flowers as Co-Op Bank Chairman only for him to be engulfed in a drugs scandal and exposed for a total lack of any banking knowledge. It was a classic case of jobs for the boys and lending made to feed politically motivated projects. To be effective, new competition has to be sustainable…that is not something the central government can deliver. In fact competition and government mix as well as oil and water.

During the financial crisis of 2007/8 the squeeze of short term liquidity meant that one of the most aggressive seekers of mortgage market share Northern Rock and the internationally ambitious RBS had to be taken into state ownership. The Labour Government of Gordon Brown sank GBP45.2Bn (USD72.3Bn) into RBS and yet the demand that it sell off branches means its value is just GBP35Bn (USD56Bn).

Given the rise of on-line or internet banking many of the leading five UK clearing banks have divested or shut branches anyway…in the on-line age the need for a physical branch is rapidly losing its significance. Indeed many would be challenger banks or alternative lenders that have emerged have expressed very little interest in physical branches.

Of course, greater…sustainable competition would be extremely welcome in the UK, however, it would be a better step if instead of playing to the crowd with fine sounding one liners or five second slogans an effort was made to think about the debate over a full hour. That way, we the public, may be better served by the politicians that seek our vote. Tackling barriers to entry (BTE) would be a good start.

BTE block potential entrants from freely entering a market profitably. They protect the market share of the incumbent firms so allowing the preservation of supernormal or monopoly profits in the long run. In short the market is less contestable. It is as Joseph Stigler has observed that the BTE represents a cost item, so a dead weight that is shouldered by a new entrant but not by those already active. The costs are then asymmetric and will raise the prospect of a new entrant incurring a loss than may serve to force their market withdrawal in the medium to long term. This could be a minefield as if the government of the day or even the Bank of England were to offer a greater degree of freedom to a new entrant what is to prevent existing UK operators or even the European Competition Commission getting involved if such freedom was denied a potential new entrant from outside the UK but still within the European Union.

This is a hot political potato that is going to be given plenty more cooking time as the election … just 16 months away draws near.

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